Monday, October 29, 2012

My pick for CEO dead pool: Omar S Ishrak at Medtronic

I got a lot of nominations for CEO dead-pool but very few with clearly enunciated reasons and the reasons are what is going to determine the ultimate winner. There were popular nominations (Meg Whitman at HP just because HP is hard, Ballmer at Microsoft for missing every major trend of the last decade).

You can't win with the obvious - indeed I was almost going to suggest that Meg Whitman was a disqualifying guess...

One entry is going to be hard to beat. Someone nominated Cynthia Carroll at Anglo American literally hours before she stepped down. But in that case the writing was on-the-wall. She was a woman and not South African and her company was causing South African politics to spiral out of control. Of course the old-guard were going to gang up on her.

In any game of dead-pool the winner has to be someone with a sterling reputation and a job they should keep for decades. And the demise should be a sudden complete surprise (at least to the company if not to the CEO dead-pool player). What will win is a company where the CEO's main job is to keep his nose clean and keep a highly profitable machine humming along and where the CEO makes a stuff up so egregious that keeping him is not within the realms of possibility.

Such a speculative guess is more likely to be wrong.

So - revealing that I am going for the most outlandish suggestion I could justify (and hence I am likely to either be wrong or to win the dead-pool game) I made my pick.

Without further ado I will introduce you to Omar S. Ishrak, the CEO of Medtronic - the largest medical devices company in the world.

Well he is the CEO for now - but my guess is not for long. After all guessing that is the point of the game.

So who is Omar S Ishrak and what did he do wrong?

Omar Ishrak is the former CEO of GE Health Care Systems now the CEO of Medtronic. He has a PhD in electrical engineering from Kings College.

Medtronic has done some dud acquisitions in the past - and those acquisitions were the main reason for the departure of the previous CEO. The main problem acquisition was Kyphon, a company with a real technology for repairing damaged spines in elderly people. Kyphon got pinged for defrauding Medicare and paid a fine. The real damage however was not the fine - it was that the required change in sales practice caused Kyphon revenues to collapse (and hence meant the acquisition price was wildly inflated).

So Omar has been clear that he will be more disciplined about acquisitions.

You can see this in the following video:

Its worth reviewing what he says in this video:

First [acquisitions] need to have a very clear value proposition which are financial in nature and very granular in their content as to why we do a certain acquisition and we need plans in place that we can deliver on those value propositions.

I think this Omar Ishrak will be forced to resign because he cannot live up to the goals he set in this video (and which he has set publicly before and since).

Indeed the acquisition he is currently doing will prove far more embarrassing than Kyphon - existence of what he is thinking he is buying may even be questioned...

The acquisition in question is China Kanghui Holdings which Medtronic is paying over $800 million for and which I think will produce a write-off of about $800 million within a year. That is, this business will be a total write-off - they will have paid over $800 million for air...

The CEO's position will be untenable after that. After all, bad acquisitions have been a Medtronic problem in the past - which is why the above video starts with the (rejected) assertion that "billion dollar acquisitions" might be a thing of the past.

China Kanghui acquisition background

I can't do any better in describing China Kanghui's business than their official description:

China Kanghui Holdings, through its subsidiaries, engages in the development, manufacture, and sale of orthopedic implants and associated instruments for trauma, spine, cranial maxillofacial, and craniocerebral. The company offers 36 product series of orthopedic implants and associated instruments for trauma and spine indications under the Kanghui and Libeier brand names. Its trauma products used in the surgical treatment of bone fractures include a range of nails, plates and screws, and cranial maxillofacial plate and screw systems; and spine products used in the surgical treatment of spine disorders consist of screws, meshes, interbody cages, and fixation systems. The company also manufactures implants, implant components, and instruments for original equipment manufacturers based on their product designs and specifications. In addition, it is involved in the development, manufacture, and sale of implants and instruments for knee joint prosthesis; and titanium alloy and cobalt alloy hip joint prosthesis. The company sells its proprietary orthopedic implants to third-party distributors, who then sell those products to hospitals directly or through sub-distributors. As of March 31, 2012, it had a network of 335 domestic distributors covering 30 provinces, municipalities, and autonomous regions in China; and a network of 41 international distributors that sell products in 29 countries across Asia, Europe, South America, Africa, and Australia. China Kanghui Holdings was founded in 1997 and is headquartered in Changzhou, the People's Republic of China.

You can see the attraction for Medtronic. It is within their industry. Most importantly it has a network of 355 domestic distributors covering much of China. Omar Ishrak would obviously be attracted to that. He has said many times that the growth of Medtronic will come from China and India: distribution in China is precisely what he wants.

This is a done-deal. Investor relations assure anyone who asks that due-diligence is complete and do not seem interested in negative feed-back (or even passing negative feed-back on). The market is trading the stock with less than 1 percent spread between the market price and bid price. There is nothing it seems that can derail this bid.

It is just that I do not see this deal as having "a very clear value proposition which are financial in nature and very granular in their content," instead I just see a mess. I could be wrong though - Medtronic have done thorough due diligence (at least according to investor relations) and I have done just a little.

China Kanghui's accounts

It is axiomatic that if you generate fake profits over time you will wind up with fake net assets on your balance sheet.

And that you can determine the profits are real by proving the assets are real, or you can determine the profits are false by proving the assets are false.

That is the nature of double-entry accounting.

If you read the accounts and you question the income you are by definition questioning the assets (or visa-versa).

So here are Kanghui's accounts - first the income account in thousand of USD.

Net revenue

51948

Cost of revenue

-14689

Gross profit

37259

Operating expenses:

Selling expenses

-6605

General and administrative expenses

-7692

Research and development expenses

-1933

Operating income

21029

Interest income

2530

Government grants

688

Other income

296

Other expenses

-299

Foreign exchange loss

-1361

Income before income taxes

22883

Income taxes

-3738

Net income

19145

Net loss attributable to non-controlling interests

94

Net income attributable to China Kanghui Holdings’ shareholders

19239

It is a mighty profitable business - on 52 million in revenue they generate 19 million in post-tax profit. The purchase price of over 800 million is an extremely fancy multiple - but they are - it appears - getting something - indeed a world-beating profit-margin in an attractive company.

They are clearly not getting an R&D team of note however - the R&D is less than $2 million and cumulative R&D is a drop in the ocean. It is not original equipment they are after then - it must be the distribution team.

Here is the balance sheet - and whoa is this an amusing balance sheet:

ASSETS

Current assets:

Cash and cash equivalents

60391

Bills receivable

933

Short-term investments

12234

Accounts receivable, net

13915

Inventories, net

17621

Prepayments and other current assets

2135

Deferred tax assets

1444

Amount due from related parties

901

Total current assets

109574

Non-current assets:

Property, plant and equipment, net

41282

Intangible assets, net

9855

Prepaid land lease payments

3624

Goodwill

24681

Long-term Investment

4004

Deposits for non-current assets

752

Deferred tax assets

388

Other assets, non-current

41

Total non-current assets

84627

Total assets

194201

LIABILITIES AND EQUITY

Current liabilities:

Accounts payable

3063

Accrued expenses and other liabilities

10389

Income tax payable

922

Deferred revenue

—

Uncertain tax positions

667

Amount due to related parties

181

Total current liabilities

15222

Non-current liabilities:

Deferred government grants

1018

Deferred tax liabilities

2361

Total non-current liabilities

3379

Total liabilities

18601

Equity:

Ordinary shares (par value of US$0.001 per share; 1,000,000,000 shares authorized as of December 31, 2010 and 2011; 136,821,600 shares and 140,401,842 shares issued outstanding as of December 31, 2010 and 2011, respectively)

162

Additional paid-in capital

145057

Accumulated other comprehensive loss

-3115

Statutory reserves

7216

Retained earnings

24847

Total China Kanghui Holdings shareholders’ equity

174167

Non-controlling interests

1433

Total equity

175600

Total liabilities and equity

194201

Inventories are 17 million dollars - not a big number - but over 400 days of cost of goods sold.

We are asked to believe that in the relatively fast changing world of medical technology this company produces world-beating results whilst keeping well over a year in inventory and doing next to no R&D.

Strangely capital equipment is over 41 million - several years of cost-of-goods sold. It is a very strange business indeed that sells medical implant equipment (small devices you can fit easily into the palm of a hand but which cost huge sums of money) which has next-to-zero R&D but plant and equipment equal to over two years cost-of-goods sold.

Moreover without any obvious change in the business the plant and equipment well over doubled in the past year.

My qualms

These accounts ask us to believe that China Kanghui is

(a). Miraculous - learning how to make a substantial medical implant business on very thin R&D,

(b). Hopeless, keeping well over a year inventory - an out-of-control stocking process, and

There is an alternative hypothesis: the profits are fake, the huge inventories and plant and equipment are a balancing item.

If the alternative hypothesis is correct (and it is only a guess) then I am waiting for and expecting Omar Ishrak's resignation. And I can't wait - I will win the game of CEO dead-pool.

On-the-ground checking

I am not the only person who has thought China Kanghui has funky accounts. Other hedge funds have paid for investigators on the ground in China - and they have tried (unsuccessfully) to report their results to Medtronic.

Alas it seems Mr Ishrak has a protective cocoon around him that makes it impossible to approach him with anything that is negative to his agenda. He probably - at least until this blog post comes out - has no idea that people think he is a misled by his staff if not personally a fool.

But for the benefit of readers let me say what the on-the-ground checking shows. Amongst other things it shows that

(a). The property, plant and equipment in the SAIC (ie Chinese domestic) accounts did not match the SEC filings. [This check is hard to do now because SAIC accounts have become unavailable.]

(b). More importantly it showed that Libeier distributors would not even distribute Kanghui products - casting doubt on the assertion that they own Libeier (and hence casting doubt on the assertion that Medtronic is even buying worthwhile distribution in China).

Of course I could be wrong

The Medtronic people say they have done thorough due diligence. I have just poked around from my office, reading the accounts, interpreting the obvious.

But my gut interpretations of accounts are right often enough, and the on-the-ground research backs them.

For an outlandish guess on CEO dead-pool this is a pretty good gambit.

No great mystery why KH's R&D costs are (relatively) so low - their devices are 'tributes' to orthopedic devices available in North America 5-10 years previously.

Capital equipment investment is interesting - haven't looked but wonder whether originates from an acquisition or from a heavy investment in growing capacity. In the context of rapidly growing manufacturing capacity, this investment is not outrageous (the equipment required is inherently expensive).

The big surprise in your points is inventory. Assuming inventory is at cost (one would hope this is correct), the overhang is actually much larger. You typically see a 90%+ margin on medical devices = which implies 3 years sales or so. I guess this suggests that the investment in manufacturing capacity is real. If only they spoke to their sales force though....

Great read. I am just curious as to why their retained earnings happens to match the net income of the last two years. I do not see where they have paid out dividends so does this mean they were only profitable in the last two years and finally overcame years of losses?

(part 1 of 2) You've hit the sector-specific nail on the head - as big medtech faces similar issues to big pharma (ex the idea that in medtech, you can lose growth but not really cash flow (viz pharma patent cliffs)).

I agree with the general proposition that Ishrak is vulnerable but none of the issues he's taking on are easy enough to solve that anyone could ask for his ouster so soon after his appointment.

More specifically, I think the major risk with this acquisition lies not with the inventory or capex positions, but with the sales practices (as you touched on with the Kyphon deal, and multiplied by an appropriate factor due to the generally shadier nature of sales practices in China (my opinion based on a couple of FCPA-type issues and broad conversations with S&M employees at companies with large Chinese presences))

I'm totally untroubled by the inventories and capex - you are correct that the actual implanted devices themselves are usually very small and very high gross margin. However, orthopedic device companies typically record the instrument sets (i.e. tools used in the procedure that implants the device) as inventory (that they never sell, but need to grant surgeons the use of in order to allow the surgeon to perform the surgery). If you look at comparables Tornier (U.S. and European extremities fixation device manufacturer) and TranS1 (U.S. minimally-invasive spinal fixation company), both carry approximately one year of inventories for these reasons.

Speculating wildly and taking a very facile view with no diligence, this looks like a company that is either very derivative (and booking through shady sales practices actual sales of produces that are just not that good) or is not respecting IP policies (which I gather range from "not that strong" to "non-existent" in China). As a part of Medtronic, it could provide a good platform for Medtronic to sell its spinal devices (not a medically-great portfolio, but still a force to be reckoned with) in China, and the risk is weighted towards an FCPA issue, which is unlikely to bring down the CEO of a $42 billion company.

I also think Ishrak could buy time if things go really sideways by separating the spine and CV portfolios (akin to Abbott's separation), which some analysts have evaluated but nobody has really pounded the table for. It doesn't make sense to have the businesses together, they each retain sufficient scale to finance optimally in the debt markets even as separate entities, and removing the spinal drag on growth would allow Medtronic to highlight its kind of interesting CV and neuromod products.

From an acquisition perspective, it's worth following Medtronic's Corevalve acquisition given its late position to market and the recent setback in Edwards' TAVR business. But it's old, not that expensive, and therefore not really Ishrak's problem.

(part 2 of 2) Now that I've merely thrown stones, I'll hope for favorable odds by picking Marissa Mayer (Yahoo). I'm speaking out of school as I'm not a tech guy, but I think she'll find Yahoo's culture more jaded and recalcitrant than Google's, and will struggle with issues of culture as the leader of the entire company. I get that running a division at Google is probably commensurate in scale and general importance to running all of Yahoo, but it's a tough task for anyone and given past attrition and activist shareholder interest (IR being an issue she didn't have to deal with at Google) I think she's vulnerable. And the Stamped acquisition is pretty laughable (acquiring the company but shutting down the product in order to acquire a team that will make the second-derivative of Google Plus?)

If you're a healthcare PM (I understand you're relatively sector-agnostic, but healthcare is an industry I follow closely) I'd look for Starks at MDT's competitor St. Jude Medical (not to be confused with the children's hospital). My thesis is:1. Negative inflection in capital deployment: STJ investors have always valued the company's high returns on capital and disciplined acquisition strategy. Case in point is the company's most recent acquisition, of AGA medical, which is turning out to be a bust after the recent failure of the company's RESPECT trial of the Amplatzer device in stroke prevention in PFO patients. This was a multi-billion dollar market and the leading product that drove the company's $1.3 billion acquisition in October 2010 (the rest of the products are either slow-growing or farther out*) and STJ should have had a more skeptical view on the trial (which had experienced serious issues with slowing enrollment**) before buying the company for such a high multiple (off the top of my head, in the 6x revenue/25x EBITDA areas).

2. Poor share price performance that could lead to activist activity: With the stock flat and underperforming over the last one, three (+12% coming off of late 09 is not great) and five years,

3. Failure to keep the CRM 'bread and butter' in order: more concerns in the CRM business (growth, margins and safety) that have dragged on the stock for the last couple years, and the hole hasn't been plugged through acquisitions.

Notes on MDT:* The general vascular plug business was growing in single-digits and growth was coming from acquiring and consolidating their distributors. The largest market opportunity outside of PFO-stroke was PFO-migraine, which was generally disregarded by the street and physicians after the failure of NMT's MIST trial. AGA would have been second to market for LAA-stroke (behind Atritech, acquired by Medtronic, though AGA had a slightly better device (easier to implant and repositionable)), and the company's nitinol graft products were slated for 2015+ launches.** Enrollment in this 900-patient event-driven trial was continually behind schedule, as patients could choose to have their PFO closed with the company's approved and marketed device in an off-label procedure, instead of taking a chance of getting randomized to the "placebo" (simulated procedure without implant) arm of the trial

After soaring from 0.20 cents/share to over $25/share during Gordon's tenure, TR has flat lined for more than a decade and at $25 is the same price it was almost 15 years ago. The Board will finally decide it's time to go in a different direction.

If written off it may look bad but it will hardly bring MDT to its knees. I'm going by memory here but I think 800M is about the free cash flow generated by MDT in one quarter. They'll survive and I doubt anything will happen to its CEO. Pissing away 800M seems to be OK nowadays.

These ortho devices are so easy to make. Small companies in the U.S. sprout up all the time to make these devices, backed by a few prominent MDs that then implant said devices in their clinics. As the first poster noted, you can easily copy/paste engineer this stuff. So, you basically have a distribution platform in China which was probably built through USD millions of guanxi. Inject Medtronics products into that platform and you can make some decent money, hopefully. No doubt the PPE is real estate of some sort, perhaps a nice office building, etc. They shuold enjoy it because I doubt Medtronic will be ponying up for much of that sort of thing over the next many years.

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